Direct listings permit companies to list securities on a national securities exchange outside of a firm commitment underwritten initial public offering (“IPO”). In a direct listing, a company has already issued and sold securities to investors, but the securities have not yet been listed on a national securities exchange. Direct listings have been permissible for years on the NYSE and Nasdaq, but previously companies could only use the direct listing process to let existing investors sell shares. Now a company can permit existing investors to sell their shares while simultaneously selling newly issued shares to the public to raise capital.

NYSE Rule Permits Capital Raising with a Direct Listing

Under the NYSE’s new rule, which is currently stayed by the SEC, the NYSE will permit a company to sell its shares without an underwriter in connection with a direct listing if it will sell at least $100 million in market value of the shares in the NYSE’s opening auction on the first day of trading. If the company wants to sell shares in the opening auction with a market value of less than $100 million, the NYSE will permit the sale of shares in connection with a direct listing if the aggregate market value of the shares the company will sell in the opening auction on the first day of trading and the shares that are publicly held (excludes shares owned by officers, directors and 10% holders) immediately prior to the listing is at least $250 million, with such market value calculated using a price per share equal to the lowest price of the price range established by the company in its registration statement.

Companies that elect to list shares through a direct listing, whether or not selling shares on the first day of trading, must satisfy all other applicable initial listing requirements, including having 400 shareholders of round lots, having at least 1.1 million publicly held shares outstanding at the time of initial listing, and having a price per share of at least $4.00 at the time of initial listing.

The registration statement filed with the SEC in connection with the direct listing must include the price range for the sales by the issuer on the first day of trading. The company selling its stock must place a limit order (“IDO Order”) for the full quantity of shares offered by the company in its registration statement with the limit price equal to the lowest price of the price range established by the issuer in its registration statement. The IDO Order may not be cancelled or modified and must be executed in full in the direct listing auction. Consistent with current rules, a designated market maker (“DMM”) would effectuate a direct listing auction manually, and the DMM would be responsible for determining the auction price. The auction will only take place if the IDO Order and all better priced sell orders can be satisfied in full — an auction would not be conducted if the auction price would be outside of the range (higher or lower), or if there was insufficient buy-side interest to satisfy the IDO Order and all better-priced sell orders in full. If the auction price is equal to the limit price of the IDO Order (i.e., the low end of the range), the IDO Order would have priority over other sell orders at that price.

Nasdaq’s Proposed Rule to Permit Capital Raising with a Direct Listing

On August 24, 2020, Nasdaq filed a similar rule change proposal with the SEC that would allow companies to raise capital in the opening auction of the first day of trading in connection with a direct listing on the Nasdaq Global Select Market.

Under Nasdaq’s proposed rule, a company could sell its shares without an underwriter in connection with a direct listing if the amount of the company’s publicly held shares before the listing, along with the market value of the shares to be sold in connection with the direct listing, is at least $110 million (or $100 million if the company has stockholders’ equity of at least $110 million). Nasdaq’s proposal should permit companies with a much smaller market capitalization to sell shares in connection with a direct listing as compared to the NYSE’s rule.

Any company raising capital in connection with a direct listing would continue to be subject to and meet all other applicable initial listing requirements, including the requirements to have 450 round lot holders (or 2,200 total shareholders), at least 1.25 million publicly held shares and a price per share of at least $4.00 at the time of initial listing.

Under Nasdaq’s proposed rule, the company must place a market order for the quantity of shares offered, as disclosed in an effective registration statement for the offering that will execute at the price determined in the Nasdaq Halt Cross. The order may not be cancelled or modified and must be executed in full. Only one Nasdaq member, representing the company, may enter an order for the sale of shares by the company during a direct listing. Unlike the NYSE rule, which stipulates that shares in a direct listing must price within the anticipated range in the registration statement, the shares offered in a direct listing on Nasdaq can be sold at a price that is up to 20% below the lowest price of the price range established by the company in its effective registration statement with no upper limit to the price. The ability to sell shares below the bottom end of the range provides companies more flexibility to sell shares than the NYSE’s rule and also allows the share price to rise well above the established range in the event of strong investor demand.

Direct Listing, IPO or SPAC?

While the direct listings of Spotify in 2018 and Slack in 2019 created much buzz and interest around this alternative path to going public, at least so far, the anticipated uptick in direct listings has not materialized. Assuming the new primary direct listing rules are ultimately approved, time will tell if the ability to raise capital as part of a direct listing — and solving an often-noted disadvantage of direct listings — will have a material impact on the number of companies choosing this route to an IPO.

If approved, direct listings would permit a company to sell shares without paying the typical IPO underwriting discount and without restrictions on the sale of shares by the company or its officers and directors that are typical following an IPO. However, the NYSE and Nasdaq rules require that a company conducting a direct listing must engage a financial advisor to assist with the initial auction of shares. Financial advisors also can be helpful in advising the company on communications and disclosures in the company’s registration statement.

Given that the market will value a company on the first day of trading under the new primary direct listing rules, the shares may be sold at a higher price in connection with a direct listing than if sold to underwriters in an IPO. Sales in connection with a direct listing also may permit a broader range of investors to participate in the IPO of a company’s stock than the traditional IPO process led by underwriters. However, companies utilizing this method of raising capital will not benefit from the underwriters’ stabilizing trading in the stock following the IPO and leading an IPO roadshow that would introduce the company to potential investors. Because of these tradeoffs, companies should consider both alternatives, as well as a transaction with a special purpose acquisition company (“SPAC”), when considering the best way to go public. As demonstrated by the meteoric rise of IPOs by SPACs over the last few years, and particularly the last several months, companies as well as investors appear to be increasingly open to and interested in alternatives to the traditional IPO.

Primary Direct Listing Uncertainty

This new direct listing path to capital raising, at least as currently proposed by the NYSE, is not supported by all participants in the capital markets. During the rule review process, certain commenters expressed concerns that “the lack of traditional underwriter involvement in direct listings generally would increase risks for investors, suggesting that direct listings circumvent the traditional due diligence process and traditional underwriter liability.” The NYSE and SEC countered this position in the approving release by noting that not all offerings require the involvement of underwriters, the broad definition of “underwriter” under securities laws would incentivize financial advisors to conduct robust due diligence and, in any event, the company and its directors, officers and experts would remain subject to liability under the Securities Act of 1933 (the “Securities Act”) for misleading disclosure. Other commenters, including CII, expressed concerns that issuers may be able to dodge shareholder claims under Section 11 of the Securities Act due to the difficulty of tracing shares purchased in the primary offering in connection with a direct listing to the registration statement of the issuer. The SEC pointed to the Slack shareholder litigation, where this argument was rejected, and noted that this challenge is not unique to primary direct listings.

Not satisfied with the SEC’s response to its three rounds of comments on the proposing release, CII filed a notice with the SEC on August 31, 2020 that it intends to petition the SEC for a review of the plan under Rule 430 of the SEC Rules of Practice (the “Rules”). Under the Rules, CII has five days to file a petition identifying the issues to be reviewed and the reasons why review is appropriate, including exceptions to any findings of fact or conclusions of law, together with supporting reasons. CII has indicated it would request review by the SEC commissioners of the SEC staff’s decision to approve the NYSE primary direct listing rule based on, among other things, the underwriting and traceability arguments outlined above. Pursuant to Rule 431, the SEC’s approval of the revisions to the NYSE direct listing rule was automatically stayed upon receipt of CII’s notice of intention to petition for review on August 31, 2020, and the SEC delivered a notice to the NYSE to that effect. The approval will remain stayed until the SEC orders otherwise. Petitioning the SEC for review pursuant to this process is a prerequisite to seeking judicial review.

Thus, the NYSE direct listing primary offering option, and its Nasdaq counterpart, remain in limbo awaiting the SEC’s review of the petition, which could be completed quickly or drag on for months.